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When it comes to applying for a mortgage, things can get tricky. Among the number of things to consider is something known as a prepayment penalty. A lot of borrowers fail to understand what it truly is, much to their own detriment even years after signing the loan documents. The sad part about this is that it’s poorly explained or simply not brought up altogether.

It’s often buried in a ton of paperwork and glossed over whenever we’re close to paying off our mortgages and getting it over with. To understand what it is and avoid such a penalty, REIA-Detroit is here to give an in-depth guide on everything you need to know about prepayment penalties.

WHAT IS A PREPAYMENT PENALTY?

A prepayment penalty basically charges you extra whenever you pay off your mortgage early. While it doesn’t sound so bad when you think about it, there are grave consequences when you incur such a penalty. However, not all mortgages come with them and they are certainly not required. Keep in mind that the money you’re borrowing comes with a stack of interest which is how lenders make a profit. For example, if you decide to repay your mortgage a year early, your lender loses a year’s worth of interest on that loan balance.

The fee is charged if you pay too quickly either by refinancing or selling your property. The fee itself is expressed as either a percentage of the loan balance or a certain number of months’ interest. The purpose of this penalty clause on the mortgage is to protect lenders against the loss of interest income that would otherwise have been paid over a period of time.

It’s important to note that there are two types of prepayment penalties, namely:

Soft Penalty

This allows the borrower to list their home on the market at any time without incurring a penalty. However, if they choose to refinance the mortgage, they will be subject to a penalty.

Hard Penalty

Whether the borrower sells their property or refinances their mortgage, they’ll be hit with a penalty. For obvious reasons, this gives you no option of jumping ship if you decide to sell your home quickly after obtaining a mortgage.

HOW DOES IT WORK?

There are some loans that have short-term prepayment penalties, but others can be in effect for as long as three to five years. In such a case, it can be very costly due to the fact that most borrowers aim to refinance before the deadline is near.

Let’s say that interest rates somehow decline three years into your mortgage. Having a penalty could prevent you from getting a better rate. But if you’ve already started with a low rate from the start and haven’t thought about refinancing in the near future, you still may need to sell your property.

A concern for most borrowers is if they’re allowed to pay extra towards their principal without triggering a penalty. Basically, you are only allowed to pay up to 20% toward your principal within a year without being charged. The caveat here is that many of these charges are known as first-dollar penalties. This means that the first dollar you pay above your monthly loan will trigger it. This essentially sets a limit from paying your loan faster than what was originally agreed upon.

I ALREADY HAVE A PENALTY – NOW WHAT?

It’s hard to get out of the penalty, especially if you incurred a hard one. However, there are a few options that you can do to work around it, such as:

Wait for it to expire

Review when the penalty is about to expire. At the same time, start looking around for any refinancing options before the due date to help you get prepared. Your lender is under no obligation to swiftly update your records so expect that it may take some time for the payoff amount to reflect on what you actually owe on your mortgage.

Refinance with the same lender

Assuming that you’re on good terms with your lender, they’ll probably let you out of your current loan without a penalty if you attempt to refinance. You have to understand though that this isn’t always the case. Even if they do let you off the hook, expect that they would still invoke a penalty on the new loan as well to make sure they still get something in return.

Sell your property

As mentioned earlier, this is only possible with a soft penalty. This type of penalty, however, isn’t too common. But if you plan to sell your home anyway, double-check your loan documents and see if you’ve been hit with any prepayment penalties before moving forward.

Pay it

If paying your penalty would improve your current situation, then we find no reason for you not to. Before you do that though, check the exact amount and when you have to pay it on the loan documents provided by your lender. It wouldn’t be a good idea to assume that your mortgage broker will know what to do, especially if they’ve closed the mortgage for you after a few years.

Understanding the type of penalty, when it expires, how much you owe, and if you’re able to make principal payments towards your loan prevents triggering it. Having to deal with a prepayment penalty can come as a shock. Not only is it such a daunting task, but it can also cost a lot as well. This can only inhibit one’s ability to sell, refinance, or even purchase an investment property.

That’s why it’s a must to work with the right people in the business to protect your financial interests. Our team of like-minded professionals at REIA-Detroit realizes that need and aim to work with our clients with their best interests. To learn more about our services, contact us at +1 (586) 800-0111.